Italy budget concerns send stocks sliding across Europe

Italy's populist coalition government has agreed to target a deficit of 2.4% of gross domestic product for the next three years, with worries about the implications sending the country's stocks plummeting on Friday.

While the official figures have not yet been released, the fiscal deficit target was leaked to the Italian media, with the structural budget deficit expected to increase, in violation of EU rules that require it to be lowered by 0.6 percentage points.

The update of the stability program will be presented to Italy's parliament on 10 October and the budget draft on 20 October after being transferred to the European Commission five days before.

Italy's FTSE Mib Index had plunged 4% by midday to 20,646.72, with the worries spreading to other indices, with Germany's DAX and CAC down 1.3% and 0.7% respectively. Italy’s banking index was down 6% and on course for its biggest one-day loss since in more than two years, led by falls in Intesa Sanpaolo and UniCredit.

The spread between 10-year government bonds from Germany and Italy widened to 270 basis points from 235bps the day before. Yields in Portugal and Spain saw no contagion, but Greek 10-year yields were up almost 17 basis points.

Still some way above its August lows, the single currency stumbled down 0.5% to a fresh two-week low against the dollar of around 1.1579.

The deficit target was well beyond the 1.6% level being pushed by the country’s finance minister Giovanni Tria but comfortably around the level deemed necessary by co-deputy Prime Minsters Luigi Di Maio and Matteo Salvini as they seek to deliver on their respective electoral promises.

This was "putting two fingers up to Brussels", said analyst Connor Campbell at Spreadex. "That decision does little to rein in Italy’s debt, as the country had promised the EU it would do."

Having estimated that Italy had fiscal space of 1% GDP, Nicola Nobile at Oxford Economics said the government appeared to be using it in full.

"This makes Italian debt much more vulnerable to external risks," said Nobile, estimating the primary surplus will decrease by around 0.5 percentage points.

The limited information available on the detailed fiscal measures suggests a "clear risk" that the Italian deficit will rise closer to the EU-set limit of 3% of GDP, Nobile said. "The two coalition parties said that the government will implement an unemployment benefit scheme, which was proposed by the Five Star Movement, and roll back part of the 2011 pension reform."

Italy's "virus" has the potential to spread rapidly in other EU countries and in particular to France and Portugal because of bank exposure to Italian debt, said Professor Costas Milas at Liverpool University’s management school.

He pointed to data from the Bank of International Settlements that suggests that French banks have quite a high exposure to Italian public and private debt, accounting for as much as 10.25% of their exposure around the world, followed by Portuguese banks with a 7.81% exposure to Italian debt.

Spanish banks have a lower exposure of 4.65%, while Milas said British and Irish banks are "fairly" immune, with Irish banks have a much lower exposure of 1.28% and British banks an even lower exposure of 0.82% to Italian debt.

With the position of the market-friendly Tria "clearly weakened" and, although his resignation has been denied, "political tensions are likely to rise", said economists at Natixis, predicting a high possibility of a downgrade to BBB- before the end of October.

"As a result, Italian bonds could experience periods of sell-off similar to those we have seen in the last months."

Natixis said Tria has "lost the game and there is a significant risk that he might resign during the following weeks", with a high degree of tension in the relations between the government and Brussels certain to prevail during the whole budgetary process.

"Then, market participants are also waiting for rating decisions, with S&P reviewing Italy on October 26th and Moody’s before end of October (a precise date still not confirmed). The significant fiscal expansion planned for the coming years is likely to materialize in an Italy’s rating downgrade to BBB-."